What This Indicator Is Saying About the S&P 500

There is no such thing as a magic indicator that will tell you when to buy and sell the S&P 500 (SNPINDEX: ^GSPC) , and we Fools do not recommend timing the market. However, Foolish investors can use the following indicator to decide whether to be fearful of a sustained market fall or not. It can also help keep you from panicking in the event of a market dip.

Moreover, being cautious doesn't always have to involve selling out of the market. For example, you could always buy some downside protection for your portfolio with a short ETF like the Short S&P Pro-Shares (NYSEMKT: SH) ETF or get some protection from volatility with the ProShares Ultra VIX Short-Term ETF (NYSEMKT: UVXY) . You could even increase your bond holdings (which can outperform in a recession) with Vanguard's Total Bond Market ETF (NYSEMKT: BND) .

Household net worth and the S&P 500The idea is simple. Most economic trends will usually manifest themselves in a change in U.S. household net worth. In turn, how U.S. households feel about their finances will affect consumption, real-estate markets, business investment, and a whole host of factors that influence the stock market. In other words, follow U.S. household net-worth trends, and you are following a sentiment indicator for the S&P 500.

The Federal Reserve publishes this data on its website. The data comes out a quarter after the period in question, but no matter -- this analysis is for strategic considerations, not for market timing.

In the graphs I use to illustrate this indicator, the correlation between household net worth and stock market performance shows when sequential growth in U.S. household net worth is below 1% for at least two running quarters.

The 1960sThere were two instances in which this correlation showed during the 1960s. The first was in Q1 of 1962, and it's a short trend only lasting two quarters. Moreover, Foolish investors should note that the S&P 500 fell 16.8% in Q2, and this surely had a negative influence on net worth. However, this impact didn't last.. In fact, net household worth then increased by 1.8% in Q3 of 1962 and by 4.8% in Q4.

Those who waited for a good quarter or two to confirm that net household wealth was rebounding were probably optimistic again when the S&P 500 reached about 66 points. In a sense, the indicator tells you not to worry too much about a stock market fall, because it isn't really caused by, or even creating, any significant drop in wealth.

The numbers on the left-hand side refer to household net worth, and the numbers on the right-hand side show the level of the S&P 500. The numbers in the middle of the graph show how many consecutive quarters saw household net worth grow by less than 1%.

]Source: Federal Reserve, Yahoo Finance, author's analysis.

The second slowdown in household-net-worth growth lasted for six quarters, during which the S&P dipped at least 20% before it went up again.

1970sWhile the 1970s began in a negative fashion, it only took three quarters before U.S. household net worth starting growing sequentially by more than 1%, with 3.4% growth recorded in Q3 1970. As the data is reported in Q4, the S&P 500 is likely to have stood around 95. The S&P 500 index then rose nicely until household-net-worth growth slowed to 0.5% in Q1 of 1973 and 0.8% in Q2.

While it's true that household-net-worth growth of 3.8% in Q3 1973 was something of a false friend -- it would have encouraged you to be optimistic around the 96-point level -- note that the cautionary indicator gave another signal in the next quarter at about 90. Furthermore, the index falls to the low 70s in the quarters afterward.

When data was released that demonstrated U.S. household net worth trending positive again, the index bounced back to about 87. Again, you would have missed some upside with the bounce-back, but you also missed the pain of the violent drop in the markets beforehand..

Source: Federal Reserve, Yahoo Finance, author's analysis.

Perhaps the most important point is that net worth increases nicely from the mid 1970s onwards, thus encouraging long-term investors to stay in the market and buy on the dips. While the increase in net worth in the 1970s is somewhat illusory in real terms (because of inflation), stock prices should go up with inflation, too.

The bottom lineIn conclusion, there is scant evidence from the 1960-1980 period to suggest that this indicator is useful for market timing, but it does appear to be a useful primer for thinking about some downside insurance in the form of the ETFs mentioned earlier. Insurance can be bought by hedging your portfolio with some short ETFS as mentioned above. Alternatively, if you are worried about a sudden and violent drop, then buying a volatility ETF may benefit you. If you are worried about a protracted slowdown, then bonds could outperform, so a bond ETF might fit the bill.

For long-term investors, the indicator simply provides a good read on the underlying strength of the economy, particularly in periods where the index is indicating weakness. In other words, it will encourage you to stay in the market when short-term noise suggests otherwise.

In the next article, I will cover the 1980-2013 period, revealing an amazing fact about the 1987 stock market crash, demonstrating how this indicator would have helped you in 2008, and ultimately arguing why investors should stay bullish right now.

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